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Sources: White House, American Presidency Project.
In some respects the chart showing the money collected by Washington looks similar to those showing federal spending, but closer comparison reveals one stark difference: When it came to spending, there were massive surges during the World Wars, which were largely reversed following each war. In contrast, on the revenue side, the federal government took more money from Americans each time the country went to war, but it largely maintained this new plateau of taxation even after the conflict ended. (This discrepancy between the patterns for spending versus taxation is possible, of course, because the government ran enormous budget deficits during the wars.) Indeed, federal spending since World War II has never come near its wartime peak of 43.6 percent of GDP, yet the wartime taxation peak of 20.9 percent of GDP was almost matched in 2000 when Uncle Sam collected 20.6 percent of GDP in revenues.
Just as we did with spending, we can break down federal revenues by major category. Since 1972 federal revenues have been dominated by the personal income tax, “social insurance” taxes (meaning the worker and employer payments for Social Security, Medicare, and other such programs), and to a lesser extent, corporate income taxes. As we discuss below, this reliance on income taxation for most revenue is the mark of an inefficient tax code; this is quite a separate issue from that of the sheer amount of resources absorbed by the federal government.
The inefficiency of a tax system isn’t of concern only to accountants and policy wonks. It has a huge impact on the economy and society. Some may find this statement surprising, since some people believe spending is more important than taxation as a measure of government’s impact on the economy. This is because, however it is financed, government spending redirects resources away from private sector uses and into politically determined channels. However, this viewpoint overlooks the way the tax system itself distorts the behavior of taxpayers, over and above the money it transfers from them to the government. In other words the way the government takes the money matters as much as how much money it takes.
To see the distortion, try this little thought experiment. Imagine the government levied a 100 percent income tax on all Americans, with no deductions or exemptions and the penalty for tax evasion was death. In such an absurd scenario, the government would collect virtually no revenue, because no one would have any incentive to earn any income. The government and the economy would collapse, and people would revert to growing food in their gardens to eke out a bare subsistence. As this intentionally extreme example illustrates, the way taxes are designed can influence a nation’s welfare and economic strength, quite apart from the amount of taxes collected.
There is a rich literature on the optimal design of the tax code.3 In other words, given that the government has a revenue objective, what is the most efficient way to extract this amount from the taxpayers? In Jean-Baptiste Colbert’s colorful phrase, “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”
Ultimately, it is impossible to design a tax code with no distortions. After all, if the government is going to take money from taxpayers, they will necessarily have less to spend or invest, and consequently their decisions must change in light of the tax burden.4 Even so, there are definite lessons coming from theoretical and historical study of better versus worse ways of levying taxes. Although economists and other policy analysts disagree on the specific details, there is widespread agreement that an efficient tax code will have the following characteristics: Simplicity, a broad base, few brackets, perhaps even a “flat” single rate, and leaving taxpayers to make their own choices between spending and saving.
Unfortunately, the US federal government offers an object lesson in how not to design a tax code. As any US taxpayer knows, the code is far from simple, requiring many frustrating hours of bookkeeping as well as explicit payments for tax software or CPA services. A study by the Tax Foundation estimated that in 2005, American individuals, businesses, and nonprofits spent 6 billion hours and $265.1 billion just to comply with the federal income tax. This staggering sum, at the time, represented 22 cents on every dollar that the I.R.S. collected in explicit income tax revenue.5
The US federal income tax has been and is quite “progressive,” meaning that it taxes more out of higher incomes than lower ones. Currently there are six income brackets, ranging from 10 percent to 35 percent. This is actually quite tame in a historical perspective; the top statutory tax rate never dropped below an incredible 91 percent throughout the entire 1950s.
The problem with high – at times confiscatory – marginal income tax rates is that they distort incentives for all income taxpayers, and the worst distortions are for the country’s most productive individuals and corporations. At very high marginal rates, wealthy investors, for instance, may well allocate their portfolio based on tax considerations (favoring tax-exempt municipal bonds and other privileged assets) rather than (pre-tax) rates of return. Highly paid executives would also have strong incentives to alter their behavior. For example, an executive might not take a new job requiring a longer commute but with a much higher salary because the federal government will absorb such a large fraction of the ostensible raise, whereas staying put allows more (untaxed) leisure time. Consequently it is harder for market signals to redirect highly skilled professionals into the niches where they would produce the most value for the economy and society.
The federal tax code is also littered with scores of deductions and exemptions that further distort incentives, as well as adding to the burden of compliance. For example, the federal tax code allows homeowners to deduct their mortgage interest expense, which effectively subsidizes homebuyers versus renters, and also gives a homebuyer the incentive to take out a bigger mortgage than would otherwise be optimal. (Further, once someone finances a home with a mortgage, he or she has less incentive to pay down the debt, due to a widespread belief that doing so “increases my taxes.”)
Beyond the problems with the design of the federal income tax is the fact that Washington relies so heavily on income, instead of consumption, taxation in the first place. In the last quarter of 2011, out of the (annualized) $2.6 trillion in total receipts collected by the federal government, 42 percent came from personal taxes levied on individuals, 13 percent came from corporate income taxes, and another 36 percent came from “contributions” to government social insurance programs.6 (This latter category will be discussed in more detail in the subsection below on entitlements.) Whatever the accounting difference between a straight-up personal income tax versus a contribution to Social Security or Medicare, the individual worker perceives both items as large bites taken out of each paycheck. Adding the three items shows that more than 90 percent of the federal government’s total receipts are currently derived from taxes levied on income in various forms.
It is well established that taxing income can be more damaging to the economy than a comparable tax on consumption (levied through a sales tax, value-added tax [VAT], or an explicit consumption tax). The primary reason for this is that a tax on income rewards consumption and punishes savers. A flat tax on consumption will neither encourage nor discourage savings; the individual knows that whenever he wants to consume, his options will be diminished by the tax at that moment. Yet under an income tax (so long as interest, capital gains, and dividends are all included in “income”) the individual is penalized when he saves. Once he earns income today (and pays tax on it), he is free to consume today with no further penalty. But if he wants to consume in the future, and therefore invests the money, he will then be hit with an additional tax on the income generated from his investment. Therefore an income tax artificially pushes people towards present consumption, leading them to save a lower share of their income than they would with a tax scheme that makes no distinction between spending and saving.
Federal Budget Deficits and Debt
The federal budget deficit represents the amount by which outlays exceed receipts; it is how much the government must borrow in a given year to meet its spending commitments. A budget surplus is the opposite, when the government collects more than it spends in a given period. The typical figure quoted for the “government’s debt” is simply the accumulation